Rules imposing clearing requirements on Europe’s interest rate swaps market took effect on June 21, as the region adopts global reforms already begun in the US and Japan.
The G20 countries agreed regulations in 2009 designed to boost transparency in derivatives markets after the collapse of Lehman Brothers, primarily through the adoption of central clearing and trading obligations, as well as new reporting requirements.
The US was the first to make good on its promise by introducing mandated swaps clearing on a phased basis in 2013, followed in 2015 by Japan. While the EU has already introduced some reforms to derivatives markets – such as reporting requirements – it has lagged others in introducing mandated clearing. Until now.
Here’s what you need to know:
What exactly was introduced on June 21?
Large banks are now required to clear certain types of interest rate swaps under the European Market Infrastructure Regulation, which implements many of the commitments the EU made in 2009 to reduce risk in over-the-counter derivatives markets.
The first clearing mandate applies only to category one firms – these are essentially the most sophisticated users of derivatives, including banks and brokers that are members of Emir-approved clearing houses. They are required to clear the most liquid type of swaps which are denominated in G4 currencies, specifically: fixed-to-float interest rate swaps, often known as plain vanilla swaps; float-to-float or basis swaps; forward rate agreements; and overnight index swaps.
Why is this so important?
Because the process of clearing is a big change for OTC markets, where often bespoke trades are entered into privately between two counterparties to hedge against movements in interest rates. Such trades will, to a lesser or greater degree, be collateralised to offer a form of insurance to one counterparty if the other defaults.
Central clearing involves a central counterparty clearing house, or CCP, standing in the middle of a trade, acting as a buyer to every seller and a seller to every buyer. In this way, a CCP mutualises risk among all its members and ensures the completion of trades, even in the case of default.
However, it is costly, requiring members to contribute to a CCP’s default fund, as well as post collateral, or margin, against each trade to cover the costs of any default. Even trades that do not have to be cleared under Emir will face tougher margin requirements under a new Basel framework – though the EU has delayed its implementation of these rules until 2017.
Simon Maisey, global head of business development at derivatives trading platform Tradeweb, said most of its client were ready for the rules, adding: “With operational processes riddled with so much complexity, it is easy to see why the market has moved early.”
Who stands to benefit from these changes?
The major beneficiaries are set to be clearing houses, most of which are now part of exchange groups. LCH.Clearnet, the clearing house majority-owned by the London Stock Exchange, is the world’s largest clearer of interest rate swaps through its SwapClear unit. Eurex Clearing, owned by Germany’s Deutsche Börse, is also a small swaps clearing franchise.
In an investor presentation in May 2015, SwapClear estimated the value of the OTC market that could be cleared, but was not, was worth around $ 60 trillion. Trading platforms, which offer connections to clearing houses and other risk management services, could also benefit.
Of course, in the longer term, the changes are designed to benefit banks and their clients by ensuring they are exposed to less counterparty risk.
What happens next?
Emir, as with other global reforms, introduces clearing on a phased basis – depending on the type of firm – to help alleviate the pressure on those that have not traditionally had to clear their trades.
The next clearing mandate – for category two firms – is December 21, 2016. These include other financial institutions, such as large buyside firms and alternative investment funds, which hold swap positions in excess of €8 billion. As of May 21, these firms have been subject to Emir’s frontloading obligation, which means that any swap agreed since that date will have to be cleared retroactively come December 21.
The third group includes financial institutions with a low level of activity in interest rate swaps, whose clearing starts later in 2017.
EU regulators can also, at any time, force swaps denominated in other currencies to be cleared. It could impose the clearing requirement on other classes of derivatives, most likely credit default swaps and commodities.
What impact will clearing have on the trading of swaps?
There has always been an expectation that the use of OTC products to hedge risks will gradually diminish, as the cost of trading them increases through clearing mandates and uncleared margin requirements, as well as punitive capital charges. Demand for cheaper alternatives such as futures and swap futures have been expected to pick up, though demand for the latter, in particular, has been weak.
Consultancy GreySpark Partners said in a June 2 report that interest rate swaps would be “transferred into the futures markets to compensate for the costs associated with EU and US central clearing mandates”.
It is worth saying that all swaps that are subject to Emir’s clearing mandate will potentially have to trade on electronic trading venues under a revised version of the Markets in Financial Instruments Directive from 2018. Such contracts will be forced to trade on a regulated exchange, multilateral trading facility or a new type of venue known as an organised trading facility, provided they are deemed liquid enough.